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exam03_notes_2up - Notes Exam 3 Additional problems and...

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Exam 3 Additional problems and review Notes: 2
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Suppose a firm has expected after-tax cash flows of $1200 per year forever (beginning one year from today). The firm is completely equity financed and has a beta of 1.3. Suppose the risk-free rate is 5% and the market risk premium is 8%. The tax rate is 35%. Ignore default risk. What is the value of the firm’s equity? What is the value of the firm’s debt? What is the value of the firm’s assets? What is the firm’s cost of equity? What is the firm’s cost of debt? What is the firm’s WACC? 3 Notes: value of equity = 1200/.154 = 7792.21 value of debt = NA value of assets = 7792.21 cost of equity = 5 + 1.3*8 = 15.4% cost of debt = NA WACC = 15.4% 4
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Now, consider the same firm, but suppose that it has restructured its capital and now has $4000 in debt. What are the after-tax cash flows for the levered firm? What is the present value of these cash flows (this is the value of the firm’s assets)? What is the value of the firm’s debt? What is the value of the levered firm’s equity? 5 Notes: Expected cash-flow = 1200 + 4000 x .05 x .35 = 1270 V = 7792 + .35 x 4000 = 9192 D = 4000 E = 5192 6
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What are the cash flows to creditors?
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